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The Enron Scandal and Moral Hazard

Prof. Leigh Tesfatsion Department of Economics Iowa State University Ames, IA 50011-1070 http://www.econ.iastate.edu/tesfatsi/ Last Revised: 3 April 2011
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Enron, the 7th largest U.S. Company in 2001, filed for bankruptcy in December 2001. Enron investors and retirees were left with worthless stock. Enron was charged with securities fraud (fraudulent manipulation of publicly reported financial results, lying to SEC,) QUESTION: In what ways are security market moral hazard problems at the heart of the Enron bankruptcy scandal?
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Brief Time-Line of the Enron Scandal

 Enron was a Houston-based natural gas pipeline company formed by merger in 1985. By early 2001, Enron had morphed into the 7th largest U.S. Company and the largest U.S. buyer/seller of natural gas and electricity. Enron was heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc.
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Brief Time-Line of the Enron ScandalContinued

On October 16, 2001, in the first major public sign of trouble, Enron announces a huge third-quarter loss of $618 million. On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry into Enrons accounting practices. On December 2, 2001, Enron files for bankruptcy.

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: Oct Dec 2001

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Regulatory Oversight of Enron

Auditors Arthur Anderson Audit Committee (Directors) Enron Board of Directors

Enron Shareholders SEC Company Report

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Investigative Findings 1993-2001: Enron used complex dubious energy

trading schemes
Example: Death Star Energy Trading Strategy

Took advantage of a loophole in the market rules governing energy trading in

California

Enron would schedule electric power transmission on a congested line from

bus A to bus B in the opposite direction to demand, thus enabling them to collect a congestion reduction fee for seemingly relieving congestion on this line.

Enron would then schedule the routing of this energy all the way back to bus
A so that no energy was actually bought or sold by Enron in net terms. It was purely a routing scheme.

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Investigative Findings

1993-2001: Enron also used complex &

dubious accounting schemes
to reduce Enrons tax payments; to inflate Enrons income and profits; to inflate Enrons stock price and credit rating; to hide losses in off-balance-sheet subsidiaries; to engineer off-balance-sheet schemes to funnel money to themselves, friends, and family; to fraudulently misrepresent Enrons financial condition in public reports.
WHY WASNT ENRON STOPPED SOONER!
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Case Study of One Accounting Scheme

(Based on WSJ site & Prof. S. Ravenscroft Notes)

Enrons rapid growth in late 1990s involved large

capital investments not expected to generate significant cash flow in short term.

 Maintaining Enrons credit ratings at an investment grade (e.g., BBB- or higher by S&P) were vital to Enrons energy trading business.
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Case Study Continued

One perceived solution: Create partnerships

structured as special purpose entities (SPEs) that could borrow from outside investors without having to be consolidated into Enrons balance sheet. SPE 3% Rule: No consolidation needed if at least 3% of SPE total capital was owned independently of Enron.
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Case Study Continued

Enrons creation of over 3000 partnerships started about 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI (Joint Energy Development Investments) fund. Enron initially thought of these partnerships as temporary solutions for temporary cash flow problems.

 Enron later used SPE partnerships under 3% rule to hide bad bets it had made on speculative assets by selling these assets to the partnerships in return for IOUs backed by Enron stock as collateral! (Over $1 billion by 2002)
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CALPERS
ENRON

JEDI
$250 Mil in Enron Stock

1993
High-Risk Assets IOUs

50% interest 50% interest

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Case Study Continued

In Nov 1997, Calpers wants to cash out of JEDI. To keep JEDI afloat, Enron needs new 3% partner.

 It creates another partnership Chewco (named for the Star Wars character Chewbacca) to buy out Calpers stake in JEDI for $383 million. Enron plans to back short-term loans to Chewco to permit it to buy out Calpers stake for $383 million.
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CALPERS
ENRON

JEDI
$383 million buyout Short-term loans $383 million

CHEWCO
This is the plan.
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Case StudyContinued
Chewco needs $383 million to give Calpers It gets.. $240 mil loan from Barclays bank guaranteed by Enron

 $132 mil credit from JEDI (whose only asset is Enron stock) Chewco still must get 3% of $383 million (about $11.5 million) from some outside source to avoid inclusion of JEDIs debt on Enrons books (SEC filing, 1997).
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Case StudyContinued
Chewco Capital Structure: Outside 3% $125,000 from William Dodson & Michael Kopper (an aide to Enron CFO Fastow) $11.4 mil loans from Big River and Little River (two new companies formed by Enron expressly for this purpose who get a loan from Barclays Bank)
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More Complications for Enron!

Barclays

Bank begins to doubt the strength of the new companies Big River and Little River.

 It

requires a cash reserve of $6.6 million to be deposited (as security) for the $11.4 million dollar loans. This cash reserve is paid by JEDI, whose net worth by this time consists solely of Enron stock, putting Enron in the at-risk position for this amount (red arrow on the next slide.)
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CALPERS JEDI
Enron now sole partner

383 Little River

Big River

Chewco
An entity supposedly independent of Enron

Barclays Bank ENRON

11.4

Kopper

240 Enron guarantee 125 11.4 132 6.6

Enron aide
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Case Study Continued

Oh, what a tangled web we weave when first we practice to deceive!

Walter Scott, Marimon, VI
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Profit to Enron from all this?

Enron received $10 million in guarantee fee + fee based on loan balance to JEDI. Enron received a total of $25.7 mil revenues from this source.

 In first quarter of 2000, the increase in price of Enron stock held by JEDI resulted in $126 million in profits to Enron.
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Profit to Enron from all this?

But everything fell apart when Enrons share price started to drop in Fall 2000 (dot.com bubble burst ). In November 2001, Enron admitted to the SEC that Chewco was not truly independent of Enron. Chewco went bankrupt shortly after this admission by Enron.
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Who is to Blame for the Enron Scandal?

Auditors Arthur Anderson Audit Committee (Directors) Enron Board of Directors

Enron Shareholders SEC

Company Report
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Who is to Blame for Enron?

Lax accounting by Arthur Anderson (AA) Co? Rogue AA auditor David Duncan (fired 1/15/02)? Enrons senior management for hiding losses in dubious offbalance-sheet partnerships? CFO Andrew Fastow for setting up these partnerships (6 year prison sentence 9/26/2004)? Timothy Belden (trading schemes, 2yrs probation 2007) CEO

Jeff Skilling (24 year prison sentence 10/23/06)? CEO Kenneth Lay (died 7/23/06 with charges pending)? Media exaggeration and frenzy? Stock analysts who kept pushing Enron stock?
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Bad Accounting Practices?

Generally Accepted Accounting Practices (Prior to 2002): Auditing companies often consult for the companies they audit (conflict of interest). Audit company partners often later accept jobs from their client companies. Companies often retain the same auditing company for long periods of time. Auditing companies have been allowed to police themselves.

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Bad Accounting Practices?

Generally Accepted Accounting Practices (Prior to 2002) Continued Appointment of Auditor Company is in theory by shareholders but in practice by senior management Audit Committee members often are not independent of senior management insiders are the ones with the most accurate understanding. Audit Committee members have typically been required to own company stock to align their incentives with those of company.
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Other Dubious Practices?

Board of Directors has traditionally been paid

largely in stock to align their interests with shareholders. Directors can sell out early based on insider information.

 When senior executives are charged with failure to abide by SEC rulings, the company typically pays the fine.

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Lessons from Enron Scandal

Demonstrated the importance of old economy questions: How does the company actually make its money? Is it sustainable over the long haul? Is it legal! Demonstrated the need for significant reform in accounting and corporate governance in the U.S. Does this necessarily mean government regulation can fix the problem?
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Sarbanes-Oxley Act (SOX) of 2002

U.S. legislative response to recent spate of accounting scandals (Enron, WorldCom, Global Crossing, Adelphia Communications) Compliance with comprehensive reform of accounting procedures is now required for

publicly held companies, to promote and improve the quality and transparency of financial reporting by internal and external auditors.

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Sarbanes-Oxley Act (SOX) of 2002

Companies must list and track performance of their material risks and associated control procedures.
CEOs are required to vouch for the financial statements of their companies. Boards of Directors must have Audit Committees whose members are independent of company senior management. Companies can no longer make loans to company directors.
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SOX Act of 2002 Continued

SOX Act essentially a response to one cause of the
financial irregularities: failure by auditors, SEC, and other agencies to provide adequate oversight. Not clear how SOX Act will prevent misuse of offbalance-sheet activities that is difficult to trace. SOX Act also does not address other key causes:

misaligned incentives (e.g., shift from cash to stock option

compensation) focus on short-run

profits rather than longer- run profit performance.

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Getting Rid of SPE 3% Rule

SPE 3% Rule: Rule permitting Special Purpose Entities (SPEs) created by a firm to be treated as off- balancesheet i.e., no required consolidation with firms balance sheets as long as at least 3% of the total capital of the SPE was owned independently of the firm. Rule raised to 10% in 2003 following Enron scandal After more misuse of rule during Subprime Financial Crisis, Financial Accounting Standards Board (FASB) replaced this rule in 2009 with stricter consolidation standards on all asset reporting (FASB 166 & 167).
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References
Chron.Com

Special Report: The Fall of Enron, www.chron.com/news/specials/enron/ George Benston et al., Following the Money: The Enron Failure and the State of Corporate Disclosure, AEI-Brookings Joint Center for Regulatory Studies, Washington, D.C., 2003
www.aei-brookings.org/admin/authorpdfs/page.php?id=242

 Prof.

Sue Ravenscroft, ISU, Enron Case Study Notes